Dan came to the first five-day trading boot camp that I ever taught. This was back in 2003, when the markets were just beginning their recovering from the dot-com collapse.
Dan was a young man, less than a year out of college. He came from a well-to-do family. And to help him get his start after finishing school, the family gave him a chunk of their trust money to trade.
He had been to an earlier course and had learned some strategies from us that had an "edge" – a positive expectancy of return over time.
But he had come to this particular boot camp to enhance his skill set even further.
Dan was a bright guy, and he understood the trading strategies quite well.
And, to his credit, he had taken to heart some earlier guidance from me to "trade small" as he started and as he continued to learn.
However, he shared with me that he was getting some pressure from his family to "grow the account."
I urged Dan to only ramp up his position size – the number of shares or contracts bought per trade – when he was confident he had a good handle on the trading strategy.
I explained to Dan that trading too many shares too quickly was not only problematic from a risk standpoint, but also from a psychological one.
I heard from Dan two times after the boot camp.
The first time he called to say that the information from the boot camp was really useful and that his trading was going quite well. I reminded him to ramp up his position size over time so that he could become accustomed to both the logistics of trading more shares and the psychological challenge of having more money in play.
You've probably guessed what happened on the next call…
Dan called my business partner, an ex-floor trader who lived in Chicago, to ask for a job. He had blown up the trust account trading positions that were just too big.
Even a system that worked well could not save the account he was trading.
There are three lessons we can take away from this all-too-frequent tale:
- Ignore proper position sizing at your own peril.
- A system is only as good as its execution.
- Our trading psychology is the key to following our system.
During our journey together, I'm going to walk you through each one of these lessons so your hard-earned wealth doesn't suffer the same fate as young Dan's.
But for today, let's concentrate on that first one…
Sizing Up the Opportunity
Last week, we talked about our trading system's two-pronged approach to risk management.
From a 30,000-foot view, risk management lets us stay "in the game" long enough for our system to work.
While watching professional poker players go "all in" in televised tournaments is thrilling, it's a losing strategy in the financial markets.
That's why we have two parts to our risk management.
In our last article, we covered the importance of sticking to our contingency exits – commonly called stop losses.
Well-placed stops can both protect your capital and improve your reward-to-risk ratio.
But even a good stop-loss plan can't save you if you're risking too much of your money on each trade.
That's where position sizing enters the picture.
Position sizing is the part of our system that answers the question, "How many?"
With a proper position-sizing plan, we know how many shares or options contracts to buy on each trade.
And young Dan from our story above is a perfect illustration of how improper position sizing can bust an account.
At the urging of family members, Dan went from successfully trading a small number of shares at a time straight to trading thousands – even tens of thousands – of shares per trade.
Regardless of the size of the account he was trading, this leap was too big for him psychologically.
Dan told my business partner that he had trouble concentrating and following the rules when the position size was big.
And then he made the biggest mistake of all: Instead of scaling back and regaining his confidence, he decided he needed to make up for the losses made while trading too many shares.
Which meant trading an even larger number of shares… until his (rather sizeable) account was blown up.
Fortunately, for us, that downward spiral does not align with our 10-Minute Millionaire way of trading.
And I tell that unpleasant tale to encourage you to take a more tried and true approach.
About the Author
Nationally recognized technical trader. Background in engineering, system designs, and risk reduction. 26 years in the markets.